Using the VIX to navigate market volatility

Opinion: Trading on the VIX isn’t as easy as it might look

CHAPEL HILL, N.C. (MarketWatch) — Fasten your seatbelts: February’s market volatility is likely to be just as high as January’s.

It might therefore be a good idea to build up your cash position and/or shift your portfolio’s asset allocation toward asset classes that are not correlated with equities.

The reason we can expect February to have a lot of volatility is simple: January did, too. In fact, the CBOE’s Volatility Index
VIX, +1.73%
jumped some 50% during the month. Research conducted by Robert Engle III, a finance professor at New York University who received the Nobel Prize in economics in 2003 for his work on market volatility, found that periods of high volatility tend to be clustered together.

A helpful way of thinking about this is the turbulence that leads airline pilots to turn on the fasten-seatbelt sign. If turbulence occurred randomly, then this requirement would make little sense. But it doesn’t occur randomly: Pockets of turbulence are clustered together, so pilots can turn on that warning sign after the first experience of such turbulence, and turn it back off after the ride has been smooth for a while.

Straightforward as this analysis is, however, many contrarian-oriented traders are reluctant to follow its logic and reduce their equity positions at times like now. That’s because they consider high volatility as a contrarian buy signal.

Yet it’s not clear that investors are missing out on much by reducing portfolio risk at the first sign of heightened volatility — and only re-entering when the markets calm down again. My research found that, contrary to what many contrarians believe, high VIX levels are not particularly bullish — and low levels are not necessarily bearish either.

The VIX’s median level over the last couple of decades — the dividing line, such that half the historical values are below it and half above it — is 18.5. As you can see in the accompanying table, the S&P 500’s average one- and three-month returns following below-median VIX levels are not much different than what they have been following above-median levels. And even if you wanted to make a big deal about these differences, you should know that they are not statistically significant at the 95% confidence level that statisticians often use to determine if a pattern is genuine.

When VIX is...

Subsequent 1 month

Subsequent 3 months

Below median

0.64%

2.02%

Above median

0.72%

2.06%

Many contrarians, of course, focus on the VIX’s relative, rather than absolute, levels. But, even here, I don’t see that traders are missing out on much if they reduce portfolio risk whenever the VIX is trading above its recent moving average — as shown in the accompanying table.

When VIX is...

Subsequent 1 month

Subsequent 3 months

< 1 month average

0.61%

1.91%

> 1 month average

0.77%

2.21%

< 3 month average

0.52%

1.73%

> 3 month average

0.90%

2.46%

Though these differences are larger than before, once again, you should know that they are not statistically significant at the 95% confidence level. In other words, there is a good probability that there, in fact, is no difference in the market’s returns following above-average volatility and low.

It is true that by being out of the market when volatility is high, you miss out on some spectacular rallies. After all, almost by definition, market bottoms — whether they be of corrections or major bear markets — occur when volatility is high. But it’s also the case that an above-average number of big down days also occur when volatility is high. Since these days largely balance each other out, there is little net loss for reducing portfolio risk whenever volatility spikes.

To be sure, you may be a thrill seeker and like staying in the market when volatility is high. If so, be my guest. Just don’t try to justify your thrill-seeking by telling yourself that, over time, you will make more money than someone who is more risk averse.

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